Common Pricing of Decentralized Risk: A Linear Option Pricing Model

Liuren Wu and Yuzhao Zhang

The Review of Financial Studies, 2025, vol. 38, issue 6, 1822-1867

Abstract: This paper proposes a top-down linear option pricing model that unifies the pricing of different option contracts not by assuming common dynamics but by imposing common pricing on each risk source in proportion to decentralized risk estimates. The model generates significantly better pricing performance than existing bottom-up models. Its high-dimensional risk structure effectively explains the options return variation, allowing for the seamless integration of option pricing with risk management. The market price of risk estimate from the model strongly predicts the future excess return of the corresponding risk-targeting option portfolio, an important dimension of attribute completely absent from prior literature.

Keywords: C13; C51; G12; G13 (search for similar items in EconPapers)
Date: 2025
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